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There seems to be a pronounced instability in investors' attitudes about the value of international investing – in vogue during certain periods, out of favor in the next.
While allocating a portion of a portfolio's overall exposure to non-European stocks can enhance long-term returns, the benefits aren't always clear to investors in the short-term. Short-term concerns, such as the relative performance of international equities against home markets or the strength of the Euro against other currencies, may override the desire for long-term benefits.
Yesim Tokat, Ph.D., an analyst with Vanguard's Investment Counseling & Research group, is the author of a recently published paper, "International Equity Investing from the European Perspective: Long-Term Expectations and Short-Term Departures." Dr. Tokat's paper analyzes the benefits and risks of investing in international stock markets, benefits and risks of investing in international stock markets, and evaluates what roles these investments should play in investors' portfolios.
Long-Term and Short-Term Perspectives
Over the long term, historical data demonstrate that the average returns and volatility of the international developed markets and European equities have been very similar. While business and stock market cycles may provide a return advantage to a region or country over certain time horizons, these differences tend to even out because developed economies grow at similar rates.
In the short term, however, developed markets can deviate significantly from these long-term expectations, creating doubts about their long-term benefits. Investors sometimes complain that the diversification benefit of international investing is not there when they need it most.
The report finds that, during bear markets, the primary benefit of international investing has been higher returns, not a reduction in volatility. By contrast, during bull markets, the benefit of investing in international markets has been diversification, not higher returns (see table 1).
Another short-term concern for investors has been the higher short-term return correlations between international markets. The report suggests that this has mostly been due to the technology bubble and the subsequent worldwide bear market, and that these correlations are likely to subside. However, if the trends of higher financial and economic integration continue, we may see higher correlations than during the past 30 years, somewhat reducing the diversification benefit.
Home-Country Bias
Among investors, there appear to be a number of behavioral biases regarding international investing. For example, European investors are significantly more optimistic about their local economies and European equities than are U.S. or Japanese investors. Partly this may reflect a certain discomfort with doing business overseas, yet it can result in a too-cautious approach regarding overseas opportunities.
As the report illustrates, however, several rational factors may justify some degree of home-country bias: in some cases, the higher transaction costs overseas, and the lack of accurate and timely information for European investors.
Still, maintaining a reasonable exposure to international stocks is beneficial for most investors. Since the return from international investments is the sum of local returns and changes in exchange rates, investors may want to utilize currency hedging to offset unexpected changes in exchange rates.
While currency hedging is often used to reduce the unexpected short-term impact of changes in exchange rates on returns, hedging does not significantly change the long-term risk or return of the portfolio, as inflation-adjusted exchange rates between currencies of developed countries roughly remain constant over the long run.
Setting Asset Allocations
The report concludes that investors should base their international allocations on their tolerance for risk and should not focus exclusively on the parameters established by the benchmarks or peer groups they follow.
Still, investors should be conscious of the trade-off between minimizing short-term regret and maximizing long-term, risk-adjusted return. Determining the right allocation depends on balancing the investor's desire for the best risk-adjusted returns against the potential regret of under-performing a benchmark or peer-group average in any one period of time.
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